[MUSIC] Hello there, students, welcome back to the Pricing Module. In this blog, we will review some general pricing approaches. In previous blogs, we have seen different factors, both internal and external, that affect our ability as a company to define prices. The logic for the general pricing approach is somehow conditioned by these factors. On one side, the bottom for our prices will be the costs of our products. We cannot sell permanently below our costs because our company would go bankrupt. And on the other extreme, the ceiling would be defined by two external elements, the price established by our competitors, and the value that our product represents for our customer. If we price our products too high, then there will be no demand, but if we price them too low, close to zero, the demand will soar, but we will not be able to sustain the company. Each of these constraints generates a different price approach. One, cost-based pricing. Two, value-based pricing. Three, competitors priority-based pricing. We will see each of them separately, beginning with the cost-based pricing approach. This is the easiest way to define a price. We take our costs, and we charge a margin. This is the reason why the system is defined as cost plus margin, also known as bottom-up pricing because we beat prices based on our lowest possible point, represented by the production cost of the product. Margins can be calculated as a percentage of cost or as a percentage of price. If we define a margin as 20% of our cost, for instance, then the final price will result by multiplying price by costs and the margin of profits. In this case, the price will be cost times 1.2. If we calculate the margins as a percentage of sales, then the calculation of our price will result from dividing the cost by 1 minus the percentage of margin. Where does it come from? If the price is equal to the cost plus margin, and the margin in a percentage of the price, then the price equals total cost plus a percentage of the price. If we switch the terms, price minus percentage of price equals cost, and therefore, the price would end up being the cost divided by 1 minus the percentage of the price. A marketer needs to understand the logic of cost accounting in order not to make mistakes at the time of defining the price that could threaten the financial and economic health of the company. In previous blogs, we said that the cost per unit of a product is composed of two elements. A, the variable costs, costs that vary directly with the production volume, and B, the fixed costs, costs that are independent of the production volume. A marketer needs to understand the concept of breakeven point, which can be defined as the amount of units a company needs to sell in order to recover all the fixed costs. The formula for the breakeven is the following: Fixed costs equals margin per unit times number of units. Therefore, the number of units equals to fixed cost divided by the margin per unit. The cost plus approach is based on the idea that this is the minimum price we need to charge to recover all our costs. But does it make sense to define your price based only on cost? Not at all. We have to distinguish cost from value. We will see two examples. If we buy a piece of land at 1 million euros, and then we buy materials for 100,000 euros, and then we build a house, paying labor for another 100,000 euros. We will have invested so far 1.2 million euros. If we suddenly decide to demolish or destroy the house, and remove the garbage costing us another 50,000 euros, the total cost could be now about 1.25 million. But what is the fair market value of the piece of land? No more than 1 million euros. The plain land, assuming that this was, in fact, the market value of the land alone. On the other side, I will give you another example. Imagine that a friend of yours sells you a 1,000 square meter flat in the upper east area of Manhattan at only $100 because he or she is your friend and loves you. By the way, the likely market price of such a flat would be dozens of millions of dollars. Are you doing good business if you sell the flat at $1,000? What has been your cost? $100. If we sell it at a 1,000 bucks, we make a margin of 90% on sales prices, or 1,000% based on cost. Again, is it good business? It seems that, in this case, we are leaving too much money on the table. With these two simple examples, almost ridiculous, I wanted to show you that the costs of a product are just a factor that establishes the bottom to price a product. But it is not the best way to define the price. We have to consider what the maximum value a customer is willing to pay for the product. And we have to consider at what prices our competitors are selling similar products to ours. If this is so clear, why is the method still widely used? Simply because of two reasons. One, it is easy to calculate, and it doesn't require lots of market research. Two, because I calculated margins as a percentage of a cost, give the idea of returns investments, which seems to generate a fair return on investment for the companies, without charging what it could be felt as abusive prices to consumers. And this has been all for this module. I hope to see you soon in the next video where we will discuss value-based pricing and competitors-based pricing. Thank you very much. Bye-bye. [MUSIC]